A common concern I hear from clients with young children is how to protect their children’s inheritances.
The best way to protect assets is through the use of a trust. A trust is a legal relationship whereby one party (the “settlor” or “testator”) gives property to another party (the “trustee”) to hold and manage for the exclusive benefit of another party (the “beneficiary”). A trust can be created during a person’s lifetime (an “inter vivos” trust) or on their death, in accordance with the provisions of their will (a “testamentary trust”), and can be used for a multitude of purposes, such as tax planning, creditor proofing, charitable giving, preserving government benefits for disabled beneficiaries, and providing for successive interests in the same property. For parents, a trust can be used to protect their child’s inheritance by appointing a third party to manage the trust property for the child until the child is mature enough to manage it himself.
Discretionary versus Non-Discretionary
There are two types of trusts: discretionary and non-discretionary.
A completely discretionary trust provides the trustee with full decision-making authority over the timing and amount of distributions and the purpose for which trust property may be distributed to the beneficiary.
In a non-discretionary trust, the trustee has no decision-making authority whatsoever with respect to trust distributions. The trustee is merely empowered to hold and manage the trust property for the beneficiary until the beneficiary becomes entitled to the trust property in accordance with predetermined instructions. The concern with non-discretionary trusts is that there is little flexibility. If the beneficiary should require funds before they’re entitled to them, the trustee won’t have the authority to distribute trust property.
Most clients opt for a combination of the two: they want mandatory distributions to the beneficiary at particular point(s) in time (such as when the beneficiary attains a specific age) with discretion for the trustee to pay out income and capital before then as and when the trustee sees fit. It’s a good idea to provide the trustee with some guidance in terms of when and for what purpose they should make distributions, such as for the health, education, support and advancement in life of the beneficiary.
Single distribution versus staged distributions
At some point in time, you’ll probably want the capital of the trust, and any accumulated income, paid out to the beneficiary. You can choose a single distribution, based on attaining a specific age or achieving a specific life event such as marriage, buying a house or completing a post-secondary degree.
However, a more common approach is to provide for multiple distributions of capital to the beneficiary upon attaining specific ages. For example, the terms of the trust may provide that one-third of the funds be paid out at age 21, one-half of the funds then remaining be paid out at age 25, and the remainder of the funds be paid out at age 30. There are several reasons why staged distributions may be preferable to a single distribution. First, parents are often concerned that their child will squander their inheritance by spending money on frivolous things, especially if their child is young or immature or has a history of financial mismanagement. If you give your child one lump sum, there is a very real possibility that they will blow through the money by living hard and fast, making poor investment decisions or being taken advantage of by unscrupulous “friends”. If you provide for staged distributions and your child squanders the first installment, they will have another kick at the can, so to speak. The hope is that the child will make smarter choices the second or third time around.
A further concern is that a child may be less motivated to work or continue their education if they are given a large sum of money. In determining an appropriate age or ages for a child to receive their inheritance, parents should consider the size of the inheritance, the child’s current and future needs, the impact of the inheritance on the child and how financially responsible the child is likely to be. There are special circumstances where it may be prudent to allow the trustee full discretion to pay out all or none of the trust funds, such as where the beneficiary is receiving government support such as ODSP that has income and asset limits, where the trust is being used to protect family wealth from matrimonial claims, or for credit proofing purposes.
Trusts can be a useful and flexible tool to protect your children’s inheritances. Do you have young children? Contact me today for a complimentary, no obligation call.
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